May 25, 2017
By Ryan Walsh
Building a successful business often entails late nights, long weekends at the office and other sacrifices that take you away from friends and family. So, when it comes time to sell, you’re going to want to get the highest price possible to compensate for all that hard work. Luckily, there are steps you can start taking now to secure a higher sale price for in the future.
But before we can discuss valuations and next steps, we must gain a clear picture of existing market opportunities.
The Big 3 research firms — Gartner, Forrester, IDC — all predict public cloud services market growth to the tune of $37 billion in 2017, and well beyond $200 billion by 2020, which should come as no surprise when one considers that the current percentage of IT budgets dedicated to cloud services is only 5 percent.
Takeaway #1: If you’re not currently offering cloud services, it’s time to start — or risk leaving $37 billion on the table this year alone.
Beyond simply delivering cloud services, technology solution providers need to package their offerings in a way that efficiently builds monthly recurring revenue (MRR). Historically, when venture capitalist firms looked to invest in or provide valuations of startups, they reviewed these three key performance metrics:
Number of Users
Cost-per-acquisition (CAC) and/or customer lifetime value (CLTV)
As more cloud-based companies were purchased, leading cloud investment firms like Bessemer Venture Partners honed the metrics associated with strong valuations. To earn a top rating, cloud product providers need to demonstrate solid returns in each of these fundamental areas. However, according to Bessemer, five key “C” metrics now rise above the others as essential top level performance indicators: CMRR (committed monthly recurring revenue), cash flow, CAC, CLTV and churn.
These factors are the proof points that a cloud-based company can deliver efficient growth. Specifically, cloud product companies that receive the high valuations have these attributes:
Committed annual recurring revenue (CARR) that exceeds 50 percent
Customer acquisition cost (CAC) payback (in months) = less than 24
Monthly churn = better than 1 to 3 percent
Customer lifetime value (CLTV)/CAC = 3x or better
Cash flow (new ARR/monthly burn) = 1x or better
While these targets are associated with companies that build and deliver high-valuation cloud products, MSPs that deliver cloud services can learn from an important combination of these metrics: efficiency of recurring revenue growth and high profit margin.
Takeaway #2: MSPs with managed recurring revenues made more money from their exits than any other service offered.
Let’s take a look at the revenue an IT service provider is earning, and what that means from entry to exit. As an expert in the field, Paul Dippell from Service Leadership Inc. has been tracking IT business valuations for years. Dippell’s research reveals that not all services are valued equally. As reported by Joe Panettieri in his article titled, “What is my MSP worth,” Dippell found that exit valuations varied greatly based on the type of service offered.
For example, the VAR portion of your business is worth 10 cents on the dollar. If you’re generating $100 million in VAR-oriented revenue per year, that piece of the business is valued at $10 million. Break-fix hourly support businesses are worth about 45 cents for each dollar of revenue. IT project or professional services businesses are worth about 63 cents for each dollar of revenue.
The true managed services portion of your business is worth about $1.27 for each dollar of true managed services revenue.
When we assess the efficiency of the recurring revenue as described in the Bessemer playbook, instead of just looking at recurring revenue, Bessemer partners now emphasize the efficiency ratio.
In an interview with Byron Deeter of Bessemer in January, Deeter said: “The efficiency rule is typically the purest way to determine the proper multiple to apply to a business.” Resellers generating recurring revenue with the higher profit margins represented as earnings before interest, taxes, depreciation and amortization (EBITDA) made significantly more than those with average margins.
Likewise, Dippell reports that average EBITDA margins of 7 percent resulted in a valuation of 5x EBITDA, whereas top-tier MSP EBITDA margins of 15 percent or greater resulted in 8x valuations.
Takeaway #3: A business with efficient MRR can sell for more than 12x a traditional break-fix and yield an 8x multiple of EBITDA.
Prior to launching Pax8, its founders created an email security solution called MX Logic. At the time of its acquisition by McAfee in 2009, the CLTV/CAC was five years. MX Logic understood and managed the 5 “C’s.” The company also focused on efficiently growing its recurring revenue through the IT channel, while also reducing its CAC. The end result was almost a 5x revenue multiple. Meaning, the leaders at Pax8 understood what it took to hit the key performance metrics necessary to earn the best VC valuation possible. We’re now focused on using these winning strategies to help technology solution providers build lucrative cloud practices.
You really can build a profitable cloud practice that sells for 12x what the average break-fix business goes for, but only if you take the right advice. When selecting a cloud distribution partner, ask them to share their qualifications with you before signing a contract.
Ryan Walsh is senior vice president of partner solutions at Pax8.
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